COLUMN-Stress tests and cargo cults: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By Jim Saft

HUNTSVILLE, Ala., July 8 (Reuters) – How are European officials orchestrating the bank stress tests like Pacific islanders speaking into coconuts and waiting for cargo to drop from the skies?

They both make the elemental error at the heart of all cargo cults; they mistake necessity for sufficiency and hope that imitation and affect will make up for a lack of substance.

Most often associated with the south Pacific after World War II, cargo cults are religions whose practitioners try to use magic to produce the results of more powerful technologically sophisticated cultures.

In the Pacific that meant making clearings in the jungle to serve as runways and donning coconut earphones and microphones with vines for wires, all in hopes that the cargo that came with American or Japanese occupation would somehow return.

In Europe it means running a bank stress test that officials hope will, like the one in the U.S. in 2009, restore confidence in its banks.

The European Union has not disclosed the methodology of the stress tests, the results of which are expected to be released on July 23 and which will cover banks with assets equaling about half of banking assets in each country.

The purpose of a stress test is to restore confidence in the banking system and, thereby, resume the flow of credit between banks, and between banks and the investors who supply banks with debt and equity capital.

The U.S. stress tests probably worked not simply because they were rigorous enough; they worked because they helped to create the belief that behind the banks stood a mighty backstop — the U.S. government.

It is not technology that Europe lacks, it is a strong central authority which lets it be known, by wink or nod, that it will stand behind the banks that pass the test or take the remedial steps that are required. That message has to get out, and even more important, the market needs to believe not just that the government will stand behind the banks, but that they have the will, means and plausible motivation to do so.

German Chancellor Angela Merkel has indicated that banks needing help might have access to the 750 million euro package of support that the EU unveiled in May, but given that many believe that will not be big enough for the countries at risk, much less their banks, that will not be sufficient.

“Mr Geithner is encouraging Europe to run stress tests because they worked so well in America. That is fine but it is only fine if you also run sovereign stress tests. A guarantee is a necessary part of this solution and that guarantee means that the real stress is on the sovereign not on the bank,” Investor John Hempton of Bronte Capital wrote in his blog, <http://brontecapital.blogspot.com>

Some European sovereigns are too weak to play that role and there is credible doubt about how far the strong will go to underwrite the weak.

DOGS AND PONIES NEEDED

Alas, it is not just the guarantor which is missing in action for Europe’s stress tests, the methodology appears to be far too easy to prompt confidence in the absence of a rich uncle.

Stress tests run scenarios to see how bank balance sheets and capital levels will be affected given different circumstances. Those scenarios make assumptions; about economic growth, unemployment, corporate profits and other factors that might lead to loan losses and bank capital erosion.

The European stress tests appear to be heading towards making, surprise, surprise, very optimistic assumptions about the value of sovereign bonds held by banks.

Reuters is reporting that the Committee of European Banking Supervisors (CEBS) will impose a haircut, or discount, of 16 percent on Greek bonds held by banks, meaning that in a stress situation the banks’ holdings of Greek debt will be assumed to hold 84 percent of their face value.

That is absurd. Credit default swaps are already pricing in a near 50 percent chance of a Greek default over five years. What is worse, recovery swaps, a derivative that allows the buyer to insure against not getting all of their money back in the event of a default, are now showing that the market thinks investors would lose 60 percent of their money should Greece default.

On those sorts of dog and pony show numbers, I am not sure the stress test would work even if Europe were both politically united and unassailably credit-worthy.

As the logic of this dawns on investors, expect European authorities to start clearing more pretend runways and calling in ever bigger shipments of phantom materiel. (Editing by James Dalgleish) (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on [SAFT/]) ((jamessaft@jamessaft.com; Tel: +1-256 715 1303))